On December 6 2002, Freddie Mac’s senior
management received two anonymous letters. One was sent by fax to
Leland Brendsel, Freddie’s chairman and CEO. One was also sent to
Ken Lewis, the chairman and CEO of Bank of America.

These letters alleged three separate problems with accounting,
public reporting and controls at Freddie Mac, including mishandling
a billing error in respect of Bank of America.

The letters also indicated that they had been widely distributed
among the press and other interested parties.

December 6 was a Friday. On the Monday, Freddie’s audit
committee brought in lawyers from Baker Botts to investigate.

On January 16, Baker Botts gave its findings to the audit
committee, presenting them to the board on January 21. It found
that the allegations contained in the letters were false.

During the course of its investigation, however, Baker Botts had
become worried by Freddie Mac’s decision to treat known balance
sheet accounting errors by smoothing the reversal of those errors
over time.

On January 22, Freddie Mac announced that it would not be able
to release audited results and on January 27 it said it would need
to reaudit its results for the previous three years.

After the collapse of Arthur Andersen, the company had brought
in PricewaterhouseCoopers to reaudit its 2002 accounts.

There had been some mistakes made in the treatment of
derivatives transactions while converting to FAS 133 — the new
accounting standard for derivatives that all US financial
institutions had been wrestling with.

PWC worried
Although the statement released to the market on January
27 referred to accounting mistakes by Freddie and Arthur Andersen,
PricewaterhouseCoopers was concerned that some of the problems it
was finding might not be mistakes.

The lawyers found that six of the items were genuine mistakes,
based in part on the advice of Arthur Andersen.

Of the other two transactions, one was immaterial — but the
other involved an attempt to smoothe operating earnings. That is
not a GAAP heading, and therefore had little practical effect on
GAAP reporting.

These interim results were reported to outside directors on
March 6, and more fully to the audit committee on April 29.

Although Baker Botts did not discover any “rampant criminal
misconduct, or abuse of authority for personal gain,” its report
did highlight “serious failures by senior management to discharge
responsibilities entrusted to and placed upon them by the
board”.

Senior management had been using capital markets transactions to
smoothe earnings growth, but the lawyers felt management had been
aware that the accounting department did not have the resources to
keep up with the complex transactions Freddie Mac was
generating.

While this investigation had been going on, investors remained
in the dark. They were still waiting for the eventual restatement
that would show Freddie’s income higher than the previous unaudited
accounts, and presumably more volatile.

There was another surprise in store, however — one that would
have lasting repercussions for Freddie Mac and raise serious doubts
about its internal controls.

Baker Botts’ investigation was almost done, when on the morning
of June 4, counsel representing David Glenn, Freddie Mac’s
president and chief operating officer, asked for a meeting in Baker
Botts’ offices on Pennsylvania Avenue.

Glenn, his lawyers said, had been under a lot of stress.

He had been in the habit, while at Freddie Mac, of taking notes
in meetings in a series of notebooks, or diaries. When Baker Botts
had asked him for his notebooks a couple of weeks previously he had
taken them home to review.

While reviewing them, his lawyers said, he had made
alterations.

Freddie’s board of directors responded by dismissing Glenn, who
had already been criticised by PricewaterhouseCoopers.

At the same time, the board accepted the resignation of Vaughn
Clarke, the chief financial officer, and the early retirement of
chief executive Leland Brendsel.

Greg Parseghian, who replaced Brendsel as CEO, has since also
been dismissed by the Office for Federal Housing Enterprise
Oversight (OFHEO), apparently for being too close to the accounting
irregularities, if not actually involved.

“As the senior vice president of funding and investments, Greg
Parseghian was involved in several of the transactions we
investigated,” said James Doty, the Baker Botts partner who led the
investigation. “However, he did not have responsibility for the
company’s accounting and disclosure.

“Like others, he was aware that the objective of some of the
transactions was to defer earnings. We believe he relied in good
faith on corporate accounting and/or Arthur Andersen to provide the
necessary accounting advice and to ensure that transactions were
accounted for in accordance with GAAP. Moreover, Mr Parseghian was
candid and fully co-operative with our investigation team.”

Parseghian is regarded as one of the best risk managers on Wall
Street and will be allowed to remain as a consultant.

Out of their depth
The Baker Botts report concluded that Freddie’s corporate
accounting department had lacked in technical skill and depth — a
deficit that extended to the controller and CFO. Senior management
failed to rectify the problem.

“Senior management’s approach to governance was such that the
information flow to the board was tightly scripted and controlled,”
Baker Botts said in its report.

The lawyers blamed the control of information on Leland Brendsel
and David Glenn. The company had been striving to maintain an image
of “steady Freddie”, an impulse which came directly from its CEO,
at the expense of management transparency.

“In those circumstances where information relevant to the
investigated transactions was contained in board materials, the
information was delivered in a manner tending to ensure that it
escaped notice and would not generate questions,” Baker Botts
concluded. “Accounting issues were presented in a way that
represented, either expressly or by clear implication, that they
were in compliance with GAAP.”

Most analysts and almost all traders of agency debt are
convinced that Freddie Mac remains securely triple-A.

Freddie has, however, suffered great damage to its reputation —
it was unable to complete its earnings restatement on time and
repeatedly postponed it.

And it still lacks a CEO who could draw a line under a miserable
year and outline a coherent vision for the company’s
future.